All Clear in Europe Now? Don't Bet on It

The European Union's Fiscal Situation Could Improve With the Latest Deal, But Many Risks Remain

By

Ben Levisohn and

Joe Light

December 10, 2011

Europe might be on sounder fiscal footing after Friday's historic pact for more coordination among nations. But investors who bet that the Continent's problems are over could be making a big mistake, say analysts and strategists.

ENLARGE

The market has big hopes for European Central Bank President Mario Draghi, pictured on Thursday.
Agence France-Presse/Getty Images

On Friday, the 17 countries of the euro zone formally agreed to run only minimal budget deficits in the future and gave the European Court of Justice the right to strike down national laws that could lead to governments overspending. Nine other members of the broader European Union said they would consult with their parliaments about joining the fiscal pact. The U.K. rejected it.

The drastic steps did little, however, to bring down the sky-high bond yields plaguing some European nations now. That is largely in the hands of the European Central Bank, strategists say.

Traders had hoped the sweeping measures being discussed this week would provide
Mario Draghi
,
the ECB's new president, with the cover he needed to embark on a large-scale program of bond buying. The Standard & Poor's 500-stock index dropped 2.1% on Thursday, after Mr. Draghi signaled that no such plan was in the works.

There is, to be sure, a sense among most investors and strategists that Europe's leaders will do whatever it takes to keep the EU from breaking apart.
John Normand,
head of foreign-exchange strategy at
J.P. Morgan Chase
,
said in a Dec. 7 report that a breakup "involves mutually assured economic depression for the region." He put the odds of a generalized breakup at about 5%, and the exit of a weak country between 10% and 20%.

Yet even if Europe solves its financial crisis and avoids a breakup, it still has to deal with its economic doldrums. Across the Continent, nations are cutting their budgets, which could weigh on growth.

UBS
predicts that there will be a 0.7% contraction in euro-area gross domestic product in 2012.
Citigroup
global equities strategist
Robert Buckland
says the EU could suffer six consecutive quarters of economic contraction. By comparison, in the 1990s, Japan had no more than three.

"There are two problems—the weak economy and the financial phenomenon," Mr. Buckland says. The financial problem "can be fixed in the shorter term. The other one isn't going to be."

ENLARGE

So how can investors protect against Europe's ongoing crisis? For starters, they should be especially leery of European stocks, says
Alain Bokobza,
head of global asset allocation at
Société Générale
.
The Euro Stoxx 50 index of European blue chips has fallen 15.2% this year, compared with a 0.1% rise in the Standard & Poor's 500-stock index. Mr. Bokobza expects U.S. stocks will continue to outperform.

In general, U.S. stocks should be less vulnerable to a European slowdown, says Citi's Mr. Buckland, because only 9% of sales by U.S. companies come from Europe. Of course, some companies are more heavily exposed. For example, both
Electronic Arts
and
Priceline.com
have 40% or more of their sales in Europe, Citi says.

Investors looking to take advantage of cheap valuations in Europe should stick with high-quality dividend-paying stocks, says
Nick Nelson,
head of European equity strategy at UBS. He recommends companies that haven't cut their payments for at least the last 10 years and also have the ability to make payments even if Europe's GDP were to drop by 2.3%, his worst-case scenario.

Such companies include
AstraZeneca
,
which has an estimated dividend yield of 7.3% in 2012 and a payout ratio of about 51% of earnings—enough cushion to support the dividend if economic growth were to slow. Supermarket chain
Tesco
sports a 4% estimated yield in 2012 and a 43% payout ratio, and
Diageo
has a 3.5% dividend yield and a 48% payout ratio.

Another way to hedge a market drop involves options. S&P 500 options are pricey now, so investors should look at options on other indexes and asset classes, says
Maneesh Deshpande,
head of U.S. equity derivatives strategy at Barclays Capital.

Mr. Deshpande also recommends looking to Japan and the Maxis Nikkei 225 Index ETF. "The Nikkei lives in its own world right now and volatility is low," Mr. Deshpande says. But he warns that "in the event of a more extreme downturn, contagion would hit the Nikkei."

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In bonds, SocGen's Mr. Bokobza and others see more trouble ahead for European government and corporate issues.

Better opportunities beckon in the U.S., strategists say. Defaults in investment-grade corporate bonds should remain low in 2012, according to Barclays Capital, which is forecasting a 4.25% total return for the category. And despite low yields—the average investment grade bond has a yield of about 3.8%—corporates have been as cheap as they are now relative to Treasurys only 10% of the time over the past 20 years, notes
Michael Gavin,
international macro strategist for Barclays Capital.

What of the embattled euro itself? It is likely to stay under pressure because even the so-called solutions to the fiscal disaster are negative for the currency, says
Altaz Dagha,
a strategist at
Westpac
in London. Austerity measures, for instance, will likely cause the euro-zone economy to slow, which is typically bearish for a currency. And if the ECB steps in to buy bonds, that could cause the euro to drop as well.

Says Mr. Dagha: "Whichever way you go, it spells weakness for the euro."

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